Matt Barrie on How to Not Get Screwed in Venture Financing

"A friendly Venture Capitalist is not the solution to your problems. You are the solution to your problems."

“Where do you think the best place is to raise money?a) Friends, Fools and Familyb) Angel Investorsc) Venture Capitalists or,d) Stock Exchange

If you think it was a trick question. It was.

This was the opening teaser to an engaging keynote provided by Freelancer.com’s CEO Matt Barrie. Matt continued to press along his keynote, labelling the core mistakes of modern startups seeking funds, and we’re excited to share with you a monster summary of tips and highlights from his talk.

Focus on Revenue Growth

“Get your MVP (Minimum Viable Product) out, get it to market and get revenue in and interact based on customer feedback.”

Your number one priority is to sell your product well. The key ingredients are listening to what your customers are saying and responding by developing your business. It’s a classic example of ask them what they want and give them what they need.

By covering the costs of running your business plus the addition of your basic living expenses -- literally enough to live on noodles -- the dynamics of your company change entirely. You are no longer desperate, VC’s don’t smell you burning through cash, and this is the key component to truly maximizing your returns.

The One Job Each Startup CEO Has: DO NOT RUN OUT OF CASH.

WATCH MATT'S FULL KEYNOTE WITH AN ALL ACCESS DIGITAL PASS

The message is quite clear. The last thing you want to do is raise money for a short period of time and lose everything in the valley of death. Ensure that you are raising enough money to demonstrate a visible increase of the company’s value. You only want to raise enough money once to get across the valley of death to get to the point of profitability. If you can’t do that, make sure that you have increased the value of the company to prevent some of the major risks later on in the game before it gets to game over.

Matt went on to relate startups with Hofstadter’s Law :

“A task always takes longer than you expect, even when you take into account Hofstadter’s Law.”

This can be applied to various degrees within operating a startup and also with investors. Venture Capitalists thrive from desperate business owners who are burning through cash. They will wait until there is nothing left to burn to get a better deal and this is the last thing you want.

Key Lessons in Funding

It’s easier to ask for more money than less money. This aligns with the need to view from an investor’s perspective and here’s how Matt followed through with a breakdown :

One of the most profitable mentalities is to think from an investor’s perspective. Ensure that the money you’ve raised sits alongside the value of the investor’s funds, that each dollar produces an ROI, and cut your losers quickly. There are countless metrics that determine if an investor is going to invest in your company or not, and these may have nothing to do with your company or metrics that are not within your control.

Asking for more money? Make sure that you’ve generated a positive ROI for every dollar you’ve raised and stretch as far as you can with every dollar raised. Most Startup Founders consciously and subconsciously lose control of their business the second they receive money from a VC. How and why does this happen?

1. Startup Founders do not position themselves as a major player or within a competitive position. They’ll accept the first deal that the first person has offered and this hurts the founders more than they are aware, as they’re guided through a blind negotiation. Have as many people interested at the same level of the pipeline as possible. This is the best position to be in, as having two or more term sheets running drives the capacity to start negotiating for a better deal. The more term sheets, the stronger to negotiation lies on your table.

2. Venture Capitalists use information asymmetry as a deal manipulation tool. Keep in mind that VCs have decades worth of experience and will utilize every tactic in their book to get the deal they want. If you focus your efforts on one section -- say for instance “I want this valuation”, the VC has a the capacity to manipulate all the terms in the investment documentations so in the event of liquidation, an IPO event, or a trade sale -- the VCs have decided what amount they will receive as a payoff based on the terms they’ve manipulated in the investment documentations, regardless if there is an undervaluation or not.

When you sign a deal with a VC, make sure they have operational experience so they don’t get too depressed with losses or too excited about gains. You need to read and understand every detail of every line of this documentation. Having an understanding of the investment documentation is absolutely essential to every startup founder and failure in understanding the investment documentation is where and how businesses fall.

Venture investing is last in, first out. This is otherwise known as “The Golden Rule.”

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In a startup, the purpose and primary role of the Board of Directors is to Hire & Fire the CEO. They are in control of setting policies and objectives, budget approvals, ensuring adequate financial resources and resolutions by a simple majority in vote or circulate resolution signed by all Directors.

The board’s tasks are not to run the company, but the board does have the above within their jurisdiction. They can fire the CEO who can appoint a new management team at any time so it’s really important to keep control of the board. Losing control of the board is effectively avalanching into your business and an easy game over situation.

Board decisions should be made effectively. Odd numbered boards are far superior in making decisions in comparison to even-numbered boards and this is represented in successful startups. Keep your board small -- compose your board of the magic 3 members, if not 5 at the most. Minimize the voices to keep your startup moving. A large party acting as your board is counterproductive when your company isn’t making any money.

In comparison to how Directors are normally determined, VCs operate in a much more lucrative way, and it’s important to recognise these actions which are found in the term sheets (as mentioned earlier when we went over Information Asymmetry) to foresee how board control is immediately lost by the Startup Founder.

This was one of Matt’s highlights of his keynote, as he shared a previous term sheet that he reviewed early on which itemized the determination of directors. This comprised of the following structure : - 2 Directors - Decided by VC’s - 2 Directors - Decided by Holders of Majority of the Shares - 1 Director Independent and unaffiliated with the Company - Independent Director voted-in separately by holders of Preferred Shares and Common Stock - VC’s have veto rights over the Independent Director

Which brings us to this..

Bringing this into clearer view, it’s an immediate 3 vs 2. There is no winning situation from this agreement for the Founder as every decision will be finalised by the voice of the VC through the unaffiliated Independent Director and this reiterates the game point of making sure you understand every detail of every line of your investment documentation.

Allocation of Returns on Exit and the Evils of Liquidation Preference

This is the bane of term sheets as a fine print and the inner evil known as “liquidation preference.”

The actual use for a liquidation preference is be utilized as a downside protection for an investor in the case where there is no return.

For example, If a Startup Founder sells the company to someone, the VC will get in return 2.5x their original purchase price and their share of the pro rata in the proceeds.

Looking at this example, let’s say the Startup Founder is raising $2 million on a $6 million pre-money (25%). If the company is acquired, the VC’s get $5 million off the top, then their share (25% of the remaining common stock) and the Startup Founder is left with zero return.

The company needs to sell for at least more than $5 million to get any value of a return for the Founder. But the pummeling from investors doesn’t stop here. The Series B investors will want at least the same deal as the Series A investors and this is brutal. It dramatically increases the required trade sale price to receive a single cent of a return.

VCs will tell you, don’t worry about your percentage of the company, just worry about growing the entire company. This is a certainty to always be concerned about your percentage of ownership.

The reality is that you will lose your control of the board, voting and veto thresholds. It is counterintuitive to want less percentage of the company than it is to have more. So be weary of this when reviewing venture documentation and manage the controls and vetos in both quantity and what they reflect.

To help you with investors with liquidation preference, a great resource is Fenwick & West who published a quarterly report of what currently is “market.” You can use this as a tool for your advantage when negotiating with VCs.

Highlights Round / Summary:

Raise enough funds to cross the valley of death and do not run out of cash

Get yourself in a competition position with VCs

With the speed at which some new companies are growing revenue, we might one day soon end up seeing a company generate a billion dollars in sales within its first year. So what are you waiting for? Get out there, raise the money, and if you can bootstrap your business -- do it. Keep your ownership high and always be in control. Do it today.